The credit crunch driven by the U.S. housing crisis appears to have hit another area of the American economy — small businesses. According to the Federal Reserve’s January Senior Loan Officer Opinion Survey (which included 56 domestic banks and 23 foreign banking institutions), 30.4 % of respondents said they had “somewhat” tightened lending standards on commercial and industrial loans to small, medium-sized and large firms, up from only 5.3 percent a year earlier. This credit tightening has forced a multitude of small business to seek alternative forms of financing

One option available to small businesses owners is inventory/receivables factoring (receivables factoring is much more widespread than inventory factoring). Unfortunately many small businesses do not fully understand factoring. The article below will define factoring, the pros/cons of factoring, and a much cheaper alternative to factoring.

What is factoring?

For receivables factoring, the invoices are assigned to the factor and they charge a fee of ~2-4% for 30 days. If for example, a small business sold a widget for $100, they billed the customer, the factor would come in and give the small business $96 today for the invoice. When the customer that bought the widget pays the invoice in 30 days, the factor receives the entire $100. Inventory can also be factored. In the case of inventory factoring, a factor will make a loan to a small business with their inventory as collateral. Rates are typically very high for inventory factoring and the loan is typically <30% of the market value of the inventory.

Pros of Factoring:

Allows small businesses to turn their working capital faster than waiting for the customer to pay the bill. Factoring provides an intermediate solution for working capital constraints. Lending decisions for receivables factoring are made based on the credit of the purchaser as opposed to the small business owner.

Cons of Factoring:

Very expensive for a small business. For example, if a factor charges 3% for 30 days, then the annualized rate is ~ 36% interest. Receivables factoring can also send the wrong message to customers. Typically factors require that the payments be remitted directly to them as opposed to the small business owner. This creates yet another possible issue if a client is late; the collections might come from the factor that is likely considerably more aggressive on collections than the small business owner.

Is there a better and cheaper alternative to factoring?

A commercial real estate loan (Hard Money loan) is often much cheaper and more effective for a small business owner The definition of “hard money” when referred to in real estate financing, is essentially a non-bankable loan. The name “hard money” is frequently interchanged with “no-doc” or private loans. For a hard money loan, the underwriting decisions are based on the borrower’s hard assets (real estate). Hard money loans typically close within 2-3 weeks. In this case, a first mortgage loan is made on the small business owner’s commercial real estate. The borrower can take cash out up to the maximum loan to value allowed by the lender. For example if a borrower owned a building valued at $1m and owed $200k, the borrower could refinance and take up to ~$600k cash out of the property (less closing costs) to put back into their business.

Pros of Hard Money: Much cheaper than factoring (rates typically range from 10-16%). Lending decisions are made based on the small business owner’s commercial real estate as opposed to their credit. A hard money loan can provide a large lump sum of cash to the borrower that can be used for working capital, etc. Finally, a hard money loan can be a long term solution to the borrowers cash needs since they can be amortized as long as 30 years.

Cons of Hard Money: The small business owner must own a commercial property with substantial equity. Most lenders only lend up to 65% of the value of the real estate. A hard money loan is typically not immediate; with the average closing time being 2-3 weeks.

Although hard money loans take longer to consummate than factoring, the long term benefits make hard money much more appropriate than factoring in most situations. Fairview lending is the leader in assisting small businesses with their financing needs including hard money loans. Fairview has assisted hundreds of small businesses throughout the country.